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How Keynes Almost Prevented the Keynesian Revolution

October 30, 1929. A brisk autumn’s day in Manhattan. The Savoy-Plaza Hotel’s thirty-three stories cast a long shadow over Central Park. At the base of the hotel a financier lies freshly fallen, motionless, while his last breath, wrenched from the lungs by force of impact, is now a red mist of gore in the air.

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Sirens and uniforms. The suicide spot quickly becomes crowded by spectators, who form a vision-impairing ring-fence of backs, much to the annoyance of elbow-throwers at the periphery. Winston Churchill stands at his hotel window looking down on the mess. To nobody’s surprise, the police will find an empty wallet and five margin calls in the dead man's pockets.1

Churchill’s curtains flutter shut, and we are left to wonder whether anyone — Churchill included — can yet see his clumsy, cigar-wielding hand in it all; whether anyone realizes that, had Churchill as Chancellor of the Exchequer only restored the gold standard at a lower exchange rate, as Keynes had recommended, the Wall Street Crash of 1929 could have been averted (or at least ameliorated).

Alas, by ignoring Keynes in 1925, Churchill triggered a calamity so severe that it not only inspired one man to kill himself beneath the British statesman’s very window but, more insidiously, also provided the impetus for the economics profession’s rejection of the “classical” axioms. As Keynes’s biographer Robert Skidelsky writes, Keynes “did not believe in the system of the ideas by which economists lived; he did not worship at the temple.” And while “in former times he would have been forced to recant, perhaps burnt at the stake, as it was ... the exigencies of his times enabled him to force himself on his church.”

1925: Britain’s Return to the Gold Standard

The pound sterling’s link to gold was severed at the start of WWI. After eleven years of unfettered inflation, Chancellor of the Exchequer Winston Churchill restored convertibility at the pre-war level of 4.25 pounds per ounce of gold.

Keynes, quite rightly, took exception to this particular detail: expecting Britain’s global customers to go on paying the same gold-price for the weakened pound was unrealistic. At this exchange rate the pound would be overvalued, and the only cure would be a sustained period of deflation — which was “certain to involve unemployment and industrial disputes.” Indeed, in 1926 a general strike crippled Britain for nine days.

What Keynes did not predict, however, was how Churchill’s blunder would later bring about an easing of monetary policy in America. And even supposing Keynes had predicted this side effect, would he have understood its implications for long-run sustainability? (Recall that both F.A. Hayek and Keynes predicted a crash would occur in 1929: Hayek because interest rates were too low, Keynes because they were too high!)

1927: At the Fed (With Cap in Hand)

American sellers (in particular) were accepting British gold in exchange for goods, but were dissuaded from returning it due to the unfavorable rate of exchange. As a result, Britain’s gold supplies diminished at a rapid rate, which made the authorities understandably twitchy: how could they keep their pledge to convert pounds into gold if they had none?

In response, the Governor of the Bank of England, Montagu Norman, set off across the Atlantic and, with much pleading, persuaded the Federal Reserve to ease monetary policy. By lowering interest rates and raising inflation, the Fed stemmed gold flows into America, giving the British a much-needed respite from the ill-effects of Churchill’s costly pound.

With this episode of soft-hearted internationalism came an upswing in the Wall Street boom and “from that date,” wrote Lionel Robbins:

In The Great Crash, a very popular account of the lead up to the Great Depression, John Kenneth Galbraith writes:

the rediscount rate of the New York Federal Reserve was cut from 4 to 3.5 percent. Government securities were purchased in considerable volume with the mathematical consequence of leaving the banks and individuals who had sold them with money to spare. The funds that the Federal Reserve made available were either invested in common stocks or ... they became available to help finance the purchase of common stocks by others. So provided with funds, people rushed into the market.

Galbraith goes on to quote a member of the Federal Reserve Board who, with hindsight, called the operation “one of the most costly errors” committed by a banking system “in 75 years.”

Galbraith finishes:

“the view that the action of the Federal Reserve in 1927 was responsible for the speculation and collapse which followed has never been seriously shaken.”

John Maynard Who?

When Keynes wrote against returning to the gold standard at pre-war parity in 1925, he did so with the expectation that he might actually influence policy. As a younger, unknown man he had worked at the Treasury for a brief stint, leaving a legendary impression; and by 1925, six years after his best-seller The Economic Consequences of the Peace, he was a famous man whose words carried weight.

It is not outlandish then to imagine a world in which Keynes got his way. In such a world, the Wall Street crash and ensuing depression might never have happened — without the costly pound, the Fed would have had no impetus to inflate. Keynes would subsequently have found the economics profession less rattled, less willing to abandon its “classical” axioms in favor of his new-fangled approach. Keynes might have averted Keynesianism.

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